Understanding Investment Risk and Reward

An important concept to
understand in investing is risk and return, often expressed as a
risk/reward ratio.  The basic idea is that the risk/reward ratio
should be about the same for any investment.  If an investor is
taking more risk, he should expect to have the chance to get a
greater return on his investment.

For example, a bank
account is a fairly risk-free investment.  Because losses in banks is
very rare — even rarer since the Government began insuring bank
accounts and requiring that banks hold a certain amount of capital in
reserve — the amount of return from a bank account is fairly low.
Bank investors do not expect a large return from their bank accounts
as long as they can reasonably expect to be able to get the money
back when they need it.  The return is actually a little worse than
inflation in fact, so wise investors only keep as much in savings
accounts as they may need in the near future.

Investing in common
stocks carries a bit more risk.  There is always a chance that a
company’s business strategy may not work, or that someone in a
company may make a big mistake, or that the company will get sued,
causing a large loss.  Even if nothing big happens, company earnings
may not grow as expected and the share price may stagnate, resulting
in an opportunity cost — money invested in a company that goes
nowhere instead of another stock that grows.  For these reasons
investors will not put money into stocks unless there is an
opportunity to make significantly better returns than in a bank
account.  Because stocks have historically had better returns than
bank accounts, investors have continued to put money into stocks.

The risk/reward ratio for different investments tends
to be nearly constant.  For example, if the risk of investing in a
bank account is 1 (some arbitrary unit), and it’s return is 2%,
such that the risk/reward ratio is 1/2 = 0.5, then if a common stock
investment is five times as risky as the bank account, one should not
invest in the stock unless the potential rate of return is at least
five times as much.  The risk/reward ratio would then be 5/10 = 0.5.

The pricing of common
stocks tends to reflect this.  If bank account yields increase, the
price of common stocks would tend to fall.  Because the return from a
bank account is now higher, the potential return from common stocks
must also be greater, so investors bid down the price until the ratio
of the current price to the expected price in the near future is
sufficient to account for the risk.

When choosing whether or
not to make an investment, the potential reward should be taken into
account.  This is the reason to avoid day trading.  In day trading,
investors buy stocks for short periods of time, often selling if very
small gains (1/8 point or less) are made.  The chance of a trade
going the investor’s way over a short period of time, however, is
about 50-50, so the chance of losing money is equal to the chance of
making money.

Since the potential
gains are very small, because positions are closed when small gains
are made, the rewards are very limited.  The risks are substantially
greater than investing in a bank account, however.  Therefore, the
risk/reward ratio of day trading is not sufficient.  Over time, one
would do much better just leaving his money in the bank.

The strategy that I call
serious investing – investing in carefully selected common stocks
and holding for long periods of time–certainly carries more risk
than investing in a bank account.  Risk is reduced, however, by the
careful selection of stocks (companies that have successful business
models and should be expected to continue to grow) and the long-term
horizon (so that the effects of market distortions do not matter).
In addition, the profit potential is substantial.  Long term
investments of a few thousand dollars have turned into millions of
dollars for companies such as Microsoft and Walmart.  For this
reason, the risk/reward ratio is very favorable.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.comor leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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